Merger Masters - The Art of Risk Arb

If you’ve worked in investing for a while, or even if you’re a private investor, I’m sure you will have come across the term Arbitrage. It comes from the French, and in investing its definition is ‘the buying and selling of securities, assets or commodities in different markets to take advantage of differing prices for the same asset.’ Quite simple really.

When we talk about Risk Arbitrage however, we’re referring to something slightly different. Risk Arbitrage, which is also known as Merger Arbitrage, is ‘an investment strategy that speculates on the successful completion of mergers and acquisitions.’ In reality this is not as simple, and as the name suggests it is arbitrage with the added element of RISK. Quite often a lot of it.

“Make the Assumption There Can be No Assumptions”

These profound Eight Words were written in thick black pen on a post-it note which I stuck to my computer monitor sometime in late 2007. At that time my job was advising Global Hedge Funds on risk arbitrage, and the words served as a daily reminder to me right through the Financial Crisis until I left that job to join another bank in 2010. I can’t tell you how much money those words saved my clients along the way, but I can say they helped us avoid recommending plenty of deals that broke. And broke ugly.

In late 2007, the world’s largest commodity company, BHP Billiton, announced it was going to take out its largest rival. China’s massive stimulus program had ignited a frenzied rally in commodity prices and the race was on for commodity companies to lock down more supply. BHP lobbied an audacious scrip-based bid for it’s iron ore arch rival RIO Tinto. The ink had only just dried on RIO’s own acquisition of Alcan, a large aluminium producer. At the time, many saw RIO’s bulking up as a defensive tactic to ward off potential bidders. There had been speculation that RIO was in the cross-hairs of numerous acquirers including the Chinese.

Once the dust had settled and BHP’s bid was live, the common assumptions that surfaced were: BHP would be willing to divest any assets required for competition authority approval; BHP’s initial bid was an opening gambit and given the significant synergies available, was sure to be raised; BHP was taking a long term view and wouldn’t be swayed by weaker commodity prices; a counter-bid from the Chinese or another miner was possible and finally; even should the deal break, BHP and RIO would trade back to the stock price ratio consistent with that prior to the bid.

BHP RIO Share Price Ratio [Source: Bloomberg]

Those assumptions ended up costing the hedge fund industry hundreds of millions of dollars. In actual fact, commodity prices weakened, BHP couldn’t extract the required synergies, debt markets closed and BHP abandoned it’s bid. On the day the deal broke, BHP’s shares rose 15% while RIO’s shares collapsed nearly 40%. The prior ratio did not hold. Expensive assumptions, indeed.

I think you would all agree that learning investment lessons from others is far preferable to doing so with your own money.

Recently I read a wonderful book on Merger Arbitrage entitled, ‘Merger Masters - Tales of Arbitrage’ by Kate Welling and Mario Gabelli. Kate and Mario have done an incredible job of bringing together many excellent tales of merger arbitrage via interviews with the world’s Risk Arbitrage Masters, and have identified the learning insights we can take from each.

The book is a must read if you’re considering adding merger-arb to your investment toolkit and it’s a useful adjunct for all investors. Like the Investment Tutorials that form the Investment Masters Class, you’ll notice some themes common to successful risk-arb practitioners. I have included a number of the pertinent points and quotes raised in the text below.

Free Calls

“Focus on finding a free call. If you were risking a really small sum of money but there was a chance for the bid to be increased, we liked to load up.” Martin Gruss

“What you’re trying to do in a deal is put yourself in a position to win the call option.” Drew Figdor

Market Downturns

“All boats- yachts and rowboats-go down together in a severe market decline. And if you’re highly leveraged, you’ll be carried out.” Martin Gruss

“Arb stocks get pounded in extreme market situations. And that’s true whether it’s your basic cyclical crash, as ‘87 proved to be, or crashes that are actual harbingers of recessions and economic crisis, like more recent examples.” Michael Price

“Sometimes everything is correlated - but that’s not anything you’ll get away from.” Clint Carlson

“I hate a merger agreement with a market escape clause - I hate it.” Karen Fineman

“Almost every long position is correlated, if the downturn is bad enough.” John Bader

Meeting Mario Gabelli at BRK 2019

Leverage

“You can’t always get it right. If you have leverage when you slip, it takes you down.” John Paulson

“If you’re running a very concentrated portfolio, you need to bring the leverage down… The wrong strategy is, ‘My arb spreads are tight so now I’m going to lever up. No, you lever up when arb spreads are wide and the opportunity is really good.” Clint Carlson

Why The Deal?

“My first and most important thought process when a new deal emerges is why is there a deal? Why does this deal make sense?” Michael Price

“The first question is not the obvious, what’s the spread? Or what’s the rate of return? It is why? What’s the motivation, Why are they doing this? Second question, What’s the valuation? Does it make any sense? Is it cheap? Is it expensive? I’d much rather invest in a deal - even if nobody comes in and tops the bid - if it’s on the low side of fair value because (a) there are that many more chances that something good will happen and (b) there’s that much less downside.” John Bader

“There’s one key element that’s going to make or break your investment and you’ve got to focus on getting that one big thing right. That’s why, to this day, my first question is, ‘Does this deal make sense? Should both parties be wanting to do this?’” Clint Carlson

“[We do] lots and lots of fundamental research work on the acquirer and the target, as well as on the industry involved trying to understand why they’re doing the deal, what they see, who the people are, and what the incentives are.” Jamie Zimmerman

“I always try to figure out: What is the industrial logic for this deal? Why are they doing it? Is it accretive, dilutive? I do a lot of valuation work and try to understand the business - because if I didn’t understand them, I wouldn’t know what risks could stand in the way of completion of the deals.” Clint Carlson

“When assessing deals, the most important factor for us - is whether there is strategic merit to the combination. Is there a strategic reason why these people are getting together? Or is it just a financing deal or a tax deal or some other motivation, which is not as strong or not as good?” George Kellner

“A deal should be a big opportunity for the buyer or a big opportunity for the seller.” Michael Price

“I’m always leery of tax-driven deals as opposed to deals driven by real business reasons.. Another red flag is a lot of debt financing. Another is sketchy earnings. You look through the products, you look through the people.” Michael Price

“Avoid politicized deals, which seem to have a tendency not to work out well.” John Bader

“Avoid the spreads where the buyer has a get-out-jail-for-free card.” James Dinan

Deals Break

“There’s risk in even ‘sure things.’” Michael Shannon

“There’s no such thing as a ‘sure thing’ and deals can break for a whole host of reasons - which can’t be foreseen. What’s more, my experiences also taught me that the insiders very often don’t know how it will turn out. Deals get done by human beings, and human beings can be fickle. Attitudes can turn on a dime. So much so that maybe a degree in psychology would be good preparation for merger arbitrage.” Martin Gruss

“There’s no such thing as a safe deal. That’s why it’s called risk arbitrage.” Clint Carlson

“No matter how sure you are that something will happen, there’s always a bit of uncertainty.” James Dinan

“I learned about risk management in the tails by experiencing very real pain.. If there is one thing I have learned - and really learned it in this business - it is that the losers are what kill you in the merger arbitrage space.” James Dinan

“Inevitably there will be broken deals. There will be fraud at a company, there may be a natural disaster - anything can happen… We deal with that by limiting our position sizes and properly diversifying.” Roy Behren

“You always have to be thinking, ‘What could go wrong'?’ Finally you need a high degree of skepticism - bordering on cynicism. You can’t take anything at face value.” Clint Carlson

Broken Deals

“If the deal breaks, you’re not losing a rate of return, you’re going to lose money.” Drew Figdor

“We hold to a general philosophy that making valuation bets on companies is not our business. So, if a deal breaks, we work our way out of related positions, ideally, methodically and carefully.” Michael Shannon

“Hoping is a terrible strategy. I try to be very disciplined about it - as in, ‘I’m here for an event. It didn’t happen. We’re out’. That is a pretty firm rule for me, and it’s painful, but how many times do you see that your first sale was your best sale? My biggest losers always started out as a smaller losses.” Karen Finerman

“There’s often real value to be found in playing the busted arb deals.” James Dinan

“Knowing where intrinsic value is means you can take advantage of the technical selling pressure from arbs unwinding - it can create opportunity. But you have to have done the work first.” Clint Carlson

“You have to have a sense of what you think the risk/reward is for holding or covering.” Jamie Zimmerman

Humility

“Hubris and bravado have no place in arbitrage.” George Kellner

“There’s a set of mind that is an absolute requirement. If’ your’re not a person whose starting point is “What am I missing?” rather than “How frickin’ great am I?” you are missing something essential to survival. “What am I missing?” is like oxygen. If you’re asking, “How great am I?” you’re the Night of the Living Dead.” Paul Singer

“If you think you’re smarter and right on deals, you’re going to go down the tubes too often. My approach is always trying to control risk by not assuming I’m right versus the market.” Drew Figdor

“Being taken to the edge and being forced to look down, it taught me something very important.. I learned that you’re not as smart as you think you are - and bad things can happen totally unexpectedly.” George Kellner

Capital Preservation

“The real key is avoiding losers.” James Dinan

“Capital preservation is the key to the risk-arb business.” Drew Figdor

“I don’t want to lose money, ever, with no excuses. My goal with investors is a combination of under promising and over delivering whenever I can. And I try not to be benchmarked. We just try to make moderate returns - as high as possible - given that our goal is not to lose money.” Paul Singer

“We always spend a lot more time trying to figure out what the downside could be than we do on the upside - and continuously update the downside calculation over time to track how the values are changing.” Clint Carlson

“The way you get really rich in this country is you live a really long time and don’t lose money - keep it compounding.” Joe Gruss

“Any young MBA can do the math. But you need judgement, experience to know when to get involved. Even then, no one is right all the time, so part of risk arb - and all investing - is managing losses, and that goes first to position sizing.” Michael Price

“The downside of the business is that when you’re wrong, it’s very painful. So you can’t be too wrong, too frequently - which makes avoiding busted deals the name of the game. Figuring out what that risk is and the probability of that risk - which is not a science, it’s a little bit of an art - is the key.” George Kellner

Skills

“I actually think the technical skills are secondary. The important stuff is creativity and a little intelligence.” Paul Singer

“The whole business, at least on the senior level, is very much an art form and it pays to be able to draw upon history.” Peter Schoenfeld

Hard Work & Channel Checks

“You’ve got to be 100% focused… The way you get or find things is by 100% focus and constant digging, finding information, and understanding the relevance of that information - because when you look back, there are always clues. You want to find those clues before the event happens.” John Paulson

“We actually go visit companies. They’re like, ‘Why are you here? Why aren’t you just asking questions on the conference call? But risk arbitrage is like the insurance business. We’re taking on the risk the deal won’t close. If you’re writing a life insurance policy on someone, wouldn’t you want to take a look, make sure they’re healthy?” Michael Shannon

“We travel to directly meet with companies, competitors, regulators.” Drew Figdor

“Start with the documents, read the merger agreement, go through the 10-K. There are no short cuts. But don’t get lulled into thinking, as some people do, that nothing else matters ‘if the merger agreement is airtight’… You can’t rely on an ‘airtight’ merger agreement.” Clint Carlson

Cyclicality

“It’s not a business for all seasons.” Paul Gould

Diversify

“We were quite risk-averse and very conscious of avoiding concentrating our positions in industries or sectors or with a specific investment banker.” Paul Gould

“If you only sell ten life insurance policies and one guy dies, it wipes out all the premium. You can’t do it, you have to be more diversified.” Michael Shannon

“Unusual things happen. That’s why you have to diversify” Jeffrey Tarr

Market Neutral

“The important thing for us is to squeeze out any directional exposure. Our goal in managing the merger-arbitrage portfolio is to create a market-neutral vehicle to provide absolute return for our investors.” Roy Behren

“The great thing about these strategies is that you can be market-neutral or uncorrelated to the market.” Jamie Zimmerman

Common Sense

“The core of a good risk-arb strategy has always been and remains, even today, despite all the computers, just common sense about where the risks are and how they correlate and don’t correlate - things that machines can’t necessarily tell you. The analysis of deal dynamics and of people’s motivations.” Paul Gould

Resilience

“As an investor, you need tenacity, resilience. Everybody makes mistakes - sometimes big - and you have to have resilience to come back, survive, make decisions amid ambiguity.” Paul Singer

“You have to remember these are essentially bets; you’re not always going to get them right. What’s more, when you’re wrong about a position, you can’t let it get in your brain so it defeats you. You have to pick yourself up and do the next deal.” Jamie Zimmerman

Low Risk and Last Mile Trades

“Nor will we play what we call ‘Last Mile Trades,’ which involve taking positions in deals that are almost certain to happen - ones with four or five days to closing that you can maybe make a nickel in. To us, the asymmetric optics of buying a position to make a nickel when - God forbid - something could go wrong and you’d lose $8.” Roy Behren

“We’ve always been highly selective. I’m not a fan of investing in vanilla, low risk-mergers. In that game, you get nine right and then you give it all back with the tenth. The merger business we tend to do is stuff that’s complicated; has hair on it.” Paul Singer

“We get involved in deals that have different characteristics, where we can trade effort for risk or complexity for risk - and that’s why our pattern of returns is so different than others.” Paul Singer

“Embrace complexity. Complexity is your friend. For the simple reason it is where you can add value.” James Dinan

“We’re not a buy and hold merger-arb spread shop. Instead we focus on being a complex, trade the events, creative shop.” Drew Figdor

Position Size

“Position sizing in arbitrage really matters because that’s what determines your success. You’ve got to be right, but if you have tiny positions in the deals than happen and a big position in one that doesn’t, you’re done. You’re toast.” Michael Price

“Before you put yourself into a position to get lucky if a bidding war or whatnot breaks out, you first have to decide, ‘How do I size this?’.. Its always tempting to look at the potential rewards but it’s much more disciplined to look at what could go wrong; what do I lose if it goes wrong; The last thing you want to do is kill yourself. You have to live to fight another day. If you size yourself appropriately and something goes wrong, you can go and make the money back somewhere else.” Jamie Zimmerman

“We basically limit our positions to 2 percent of the portfolio. So our basic metric in the worst case we can anticipate, we’re not going to lose more than 2 percent of our capital. Over the many years that worked pretty well for us.” George Kellner

'“The game plan is not to be the Babe Ruth of the business. In other words, I want to have a 0.300 batting average wherever possible, but I don’t need to hit sixty-one home runs, or whatever Roger Maris hit, to break the Babe’s record. Consistently hitting singles and doubles is just fine.” George Kellner

People

“You have to know the cast of characters.” Michael Price

“Its crucial to assess who is pulling the strings and to understand what assumptions they are operating under and to assess whether they are realistic or not.” Peter Schoenfeld

“All the probabilities built into your best models - they don’t apply when it’s just one person, one decision.” James Dinan

“I also care who the lawyers and bankers are. I care if it’s the A-team, because the A-team get deals to the finish line.” Karen Finerman

“We should always want to think about: Does the CEO have his board behind him?” John Bader

“I've long considered management-led leveraged buyouts to potentially be the most egregious form of insider trading. If management participates in a buy-out group, you know they have hidden jewels.” Mario Gabelli

“Watch what the smart guys do. Today, that might be Jeff Immelt or Seth Klarman, Warren Buffett or Charlie Munger.” Michael Price

Summary

You can see that many of the principles of value investing are present in Risk Arbitrage as well. No one has a clean batting record; all of us will, and do, fail from time to time. Acknowledge your mistakes and pick yourself up and get on with it. Spread yourself rather than place all your eggs in one basket. Focus on the downside first.

Mario’s comment that if ‘management are involved in a buy out group, you know they have hidden jewels’ is a valuable insight. Look to the people involved for the real clues as to whether the merger has legs. All the research in the world won’t necessarily give you insight into people’s intentions, and the ‘why’ of the matter is crucial to success in this field. Why are they merging, indeed.

As the name suggests, Risk Arbitrage is fraught with peril. Never make the assumption there are no risks. And while things can go wrong, risk-arb can provide attractive returns if you use common sense, work hard and manage risk appropriately.

“There’s no way anyone could get bored with this business.” Paul Singer

Knowledge is the key, as it is with all investing. The information you glean from reading and meeting and talking and analysing makes all the difference in the world. I’ll let Mario have the last say:

“You don’t have to have good hand-to-eye co-ordination to be a good investor if you have the benefit of accumulated and compounded knowledge.” Mario Gabelli

Further Reading:
Merger Masters: Tales of Arbitrage - Kate Welling & Mario Gabelli. (Columbia Business School Publishing)
Investment Masters Class - The Arbitrage Series - Part 1
Investment Masters Class - The Arbitrage Series - Part 2

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

The Arbitrage Series - Part 2

'Merger arbitrage', a form of 'risk' arbitrage, is the term given to buying stocks involved in a takeover situation to capture the spread between the market price and the takeover price. The target stock usually trades at a discount to the takeover price to reflect the risk the takeover fails as well as the time value of money until the deal completes.  

However, unlike 'classic arbitrage,’ there is a risk the deal won't happen. If a deal breaks, the target stock price generally falls back towards it's pre-deal level [the price can fall lower or retain some of the premium depending on the situation] leading to large losses. Thus the term 'risk arbitrage'.  

In a cash deal, the investor will buy the target's shares at a discount to the takeover price which are exchanged for cash at deal completion. In a scrip deal, the investor will buy the target's shares and short the acquirer's shares, in the appropriate ratio, to lock in the 'spread'. At completion the target's shares will be exchanged for the acquirer's shares which will be used to net off the short position.  

"Say you get a $50 offer from a company that was trading at $35 and it immediately jumps to $49. Now most investors don't want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home. On the other hand, the arbitrageur steps in, and for that extra dollar, takes the $14 risk of deal completion. Now a dollar may not sound like a lot. But a dollar over $50 is roughly a two percent return. And let's say it's a tender offer and will close in 60 days. That means you can do the deal six times a year so six times two is a 12 percent rate of return. That can be an attractive rate of return for a relatively short term investment." John Paulson

The key attraction of merger arbitrage compared to investing in a company based on fundamentals is that you are less exposed to the broader influences of the stock market given the somewhat specific price and time outcome.

"The beauty of arbitrage is you can earn good returns that are non-correlated with the market." John Paulson

However, in stressed markets and/or economic environments, merger arbitrage returns tend to become more highly correlated with the broader market given financing can dry up, market-out and/or material adverse change clauses get triggered, and funds face redemptions.

Buffett has been actively involved in merger arbitrage in both the Buffett Partnership, and then, Berkshire Hathaway. Buffett only participated in ‘announced’ deals, unlike many investors who look to participate in pre-announced deals, where a deal maybe rumoured [rumourtrage], a company may disclose they are considering corporate actions/strategic alternatives or there is speculated to be further corporate action given significant merger activity in a sector.

"The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumours or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities." Warren Buffett, 1988

Merger arbitrage is a specialised area requiring skills in valuation, portfolio/risk management, takeover laws/regulatory rules, industry dynamics, human psychology, tax rules etc.

"A legal education helps us in the analytical process. It instills discipline." Brian Stark

“One of the things you have to be good at in the risk arbitrage business is valuation: you need to be able to understand your downside.” John Phelan

"To be successful requires very specialised skills unique to the arbitrageur. One must be an expert in evaluating the financing, legal, regulatory, accounting, market and business issues that may affect a deal's outcome. To properly evaluate these risks, the arbitrageur must have expertise in analysing merger agreements, financing agreements, strategic issues and financial statements, as well as federal, state and local regulatory issues." John Paulson

Given the merger 'spread' is normally quite slim, the profits from merger arbitrage tends to be small relative to the loss you can incur if a deal fails. In the example above, an investor risked fourteen dollars to make one dollar. This asymmetry is why it is analogous to 'picking up nickels in front of a steamroller'.

“The strategy, while properly executed, can produce non-correlated, low-volatility returns, [however] any individual deal may carry substantial risk. This is because the upside in a transaction is very small compared to the potential downside. While the annualised return may be high, the absolute return is small, and the downside can be 10 times, 20 times or even 30 times the amount of potential gain.” John Paulson

“When things go wrong in merger arbitrage, they can go very wrong – often in an asymmetric way.” Joel Greenblatt

"Premiums, ranging generally from 10 percent to even 50 percent - exceptionally even 100 percent - maybe offered for acquisition targets. An arbitrageur, when he takes his long position, is thereby assuming a great part of this premium in the price he pays. Should the deal be sabotaged for some reason, the downside price slide can be rather large. So one must carefully calculate the downside risk." Guy Wyser-Pratte

To make money in merger arbitrage the investor needs the deal to complete. As a starting point it's worth considering a few basics. Prior to analysing a deal it's worth asking a few questions with regards to the jurisdiction of the deal. Roddy Campbell of Cross Asset Management poses the following three questions: Is there, 1) a level playing field? 2) a decent body of precedent of corporate law decisions? and 3) an ability to predict the behaviour of participants and comprehend their motives? If you answer NO on any of those, it's probably best to move on t0 the next opportunity.

It's worth establishing a checklist of key considerations to ensure items are not overlooked. Some considerations include:

Deal type - is the deal announced or rumoured? Announced deals carry significantly lower risk.
Type of Buyer - is the buyer a financial buyer [ie private equity] or a strategic buyer? If private equity, is management participating? what do they know? Sensible strategic acquisitions by larger corporates in the same industry tend to have a higher likelihood of success [in the absence of competition issues] than financial buyers.
Nature of Target - was the company being shopped for sale? A company being shopped means the company is 'in play' and the board is open to a transaction. Other buyers may emerge if the deal breaks. Conversely, the list of alternate buyers may already be exhausted. If the market was aware the company was being shopped the pre-deal price is likely to have some takeover premium in it which may disappear if the deal breaks.
Type of Bid - is the buyer paying cash or scrip, a combination of both, or some other form of payment? Is the deal a takeover, scheme of arrangement or other type of transaction? 
Borrow - if the deal is a scrip deal, is there ample borrow? What are the borrow costs?
Hostile or Friendly - has the seller agreed to the terms of the deal or is it a hostile takeover? Friendly deals have a much greater chance of proceeding.
Size of the deal - is the target company a small or large company relative to the buyer. Smaller deals relative to the size of the acquirer tend to be lower risk.
Funding of the Buyer - if a cash bid, does the bidder need/have financing in place and if not what is the appetite among lenders? Are the financial metrics acceptable, is the acquirer or the proposed combined entity too heavily geared? Will the financial metrics limit the acquirers ability to pay more?

"Among other things, it's offer was contingent upon obtaining 'satisfactory financing'. A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage." Warren Buffett, 1988

Value of the target - are the deal metrics comparable with other takeovers? Is the company valuation fair at the bid price? Could the bidder pay more for the company? A low valuation increases the chance of a contested bid and generally means less downside risk. A target or their shareholders, however, are more likely to reject a hostile bid at a low valuation.
Track record of Buyer - does the buyer have a track record of closing similar transactions?
Synergies of the deal - what is the upside from putting the companies together, how important is the deal to the acquirer? Could another party get more synergies?
Target Agreements - do the target's customers, financiers, suppliers etc have change of control clauses?
Shareholders of the target - will the target shareholders agree to the deal and is there any shareholder or group of shareholders who could block the deal? Are there any other corporates on the register who may bid?
Pre-bid stake - has the acquirer already built up a stake in the target? i.e. how committed are they? Is it sufficient to block alternative bids?
Break fees/No Shop clauses - is the acquirer/target liable for break fees? Will they put off another buyer? Is the target prevented from seeking a higher bid?
Post deal announcement price of the acquirer - has the market reacted favourably to the proposed acquisition? Are the acquirer's shareholders supportive of the transaction?  
Potential Counter bidders - is it likely another buyer for the company will emerge? The potential for a contested takeover can improve the asymmetry of returns.

"Generally, the characteristics that lead to a higher bid include: a low relative valuation, an attractive target, an industry experiencing consolidation, no lock-ups and the company not having been shopped prior to deal announcement." John Paulson

Acquirer bid - is there a chance another party could bid for the acquirer? Was the acquirer buying for defensive reasons? Will the deal break if an offer is made for the acquirer? This is a major risk to a trade, particularly if you have bought the target and short the acquirer. 
Fraud - Is the acquirer buying to mask an earnings hole/structural decline in their own business? Is the target likely to reject the acquirer's scrip? Are there question marks over the acquirers financials/cash flows/roll-up strategy?
Conditionality of bid - does the bid have few or a lot of conditions that need to be fulfilled for the deal to complete? How onerous are the conditions? The more conditions, the more chance of a deal break.
Market Out-clause - does the bidder have a market out-clause if stock markets or commodities etc fall or interest rates rise? Absence of out-clauses reduce the risk of a deal break.
Defence Options - what could the target company do to scuttle the deal, poison pills etc?
Anti-trust/Competition issues - are there any issues which may mean the deal is blocked by a competition regulator? Are there useful precedents?
Timing/Delays? - are there likely to be delays to the completion time? Competition /regulatory/ court rulings/ due diligence etc. Delays ordinarily reduce the returns unless the deal compensates for a delay in the timetable.
Regulatory Issues - are their regulatory issues outside competition? Are there national interest/sovereign issues? Is the deal in a country with a strong rule of law? Are there deal precedents?
Tax Issues - does the deal require a favourable tax ruling?
'Break' downside - where is the stock likely to trade if the deal breaks?  Does the bid highlight value not previously appreciated by the market, or is it likely to fall back to levels prior to the deal being announced or speculated? Is there a risk that new and disappointing information may come to light during the negotiation?
Company Performance - the underlying performance of both the target and acquirer can impact the probability of a deal closing. The more cyclical the industry the more risk either party's business may change significantly which may alter the deal outcome.

The investor must consider the above issues at a minimum to determine whether to participate in a deal. Every transaction is different.  

Often investors will work out a probability weighted outcome based on different scenarios [ie 15% chance of deal break which will see stock fall to 5% below undisturbed price [ie price stock trading before deal], 60% chance of deal complete at stated time, 25% chance of competing bidder paying 20% more for target]. The investor will calculate the annualised return the current spread provides. The difficulty is in weighing up the factors and estimating the probabilities.

"It's very easy to compute what the returns are from a spread. But what's not easy to compute is what the risks of the deal breaking apart are." John Paulson

The investor is unlikely to have concrete answers to all the necessary questions and will need to make informed judgements.   

"In arbitrage you have to be able to pull the trigger, even when your information is imperfect and your questions can’t all be answered. You have to make a decision: should I make this investment or not? You begin with probing questions and end up having to accept that some of them will be imperfectly answered – or not answered at all." Robert Rubin

"One of the things I do very well in investing is I gather a lot of information, but I never know the whole picture. I have a lot of inputs, but never everything. And I have to make a decision on incomplete information. And I feel very comfortable doing it." James Dinan

"Investing isn't black or white. It's different shades of grey, and what was common to all of us [in Goldman's risk arbitrage team] was that we could see the different shades of grey and handicap them. There were very few second chances. The process had to be good." Richard Perry

The investor must constantly monitor the takeover's progress as well as general market and industry conditions to manage risk and optimise returns.  

"The odds of a merger reaching closure changed constantly over time, as risks emerged and receded and share price fluctuated. We had to stay on top of the situation, recalculating the odds and deciding whether to commit more, reduce our position, or even liquidate it entirely." Robert Rubin

"Merger arbitrage is not a one decision investment. It is an ongoing process: prices fluctuate, the economy changes, government actions are taken, stock is always being bought and sold. Merger arbitrage is not a part-time activity. It required constant vigilance." Ivan Boesky

Ultimately, an investor must be comfortable with the worse case outcome and the effect on their overall portfolio. I've seen plenty of situations where a deal break results in a share price trading significantly below the pre-bid trading price. For example when a takeover premium was already in the price and the register has become dominated by non-natural holders who need to sell, an acquirer walks due to any one of a number of possible reasons, or the target fails to act in the shareholder's best interests.   

“Risk arbitrage sometimes involved taking large losses, but if you did your analysis properly and didn’t get swept up into the psychology of the herd, you could be successful. Intermittent losses – sometimes greatly in excess of your worst case expectations – were part of the business.” Robert Rubin

Pure merger arbitrage funds limit position sizes and look to participate in many transactions to spread risk and minimise the loss from a single deal breaking.     

"Of course, an arbitrageur would be involved in many deals at any one time. You had to do a lot of them, because arbitrage is an actuarial business, like insurance. You expect to lose money in some cases but to make money over the long run thanks to the law of averages.” Robert Rubin

"A common approach to managing a merger arbitrage portfolio is to diversify a portfolio across a broad range of small positions. By minimising position sizes, the manager can protect himself from significant drawdowns [loss] in the event of an adverse deal outcome. This broadly diversified approach, however, should lead to no better than average returns." John Paulson

“Of course, some investment strategies for instance, our efforts in arbitrage over the years require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment - one that indeed has a significant possibility of causing loss or injury - if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favoured by probabilities, but refuse to accept a single, huge bet.“ Warren Buffett

While Warren Buffett recognized the benefits of a diversified approach he tended to concentrate in a small number of attractive deals. The merger activity was part of a broader portfolio of investment styles that could absorb any large loss.

"Our relatively heavy concentration in just a few situations per year (some of the large arbitrage houses may become involved in fifty or more workouts per annum) gives more variation in yearly results than an across-the-board approach. I feel the average profitability will be good with our policy." Warren Buffett, Buffett Partnership Letter

"Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation. So far Berkshire has not had a really bad experience. But we will - and when it happens we'll report the gory details to you." Warren Buffett, Berkshire Letter

“We do not do a lot of arbitrage, but participate in extreme opportunities.” David Einhorn

Like many investment strategies, when there has been a history of returns money flows into the strategy which lowers its returns. Similarly, in the absence of deals, too much money chasing too few opportunities affects returns.

Easy credit and a bull market leads to increasing deal activity and the potential for contested deals. The merger boom leading into the Financial Crisis was a case in point. Deals regularly traded at premiums to the takeover prices as a credit bubble fueled a private equity buying binge resulting in a flurry of contested deals. Sell-side research analysts spent their days running LBO screens over company financials to identify the next potential target. All was well until the credit markets closed.

“When an area of investment such as risk arbitrage or bankruptcy investing becomes popular, more money flows to specialists in the area. The increased buying bids up prices, increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy. This attracts still more investors, bidding prices up further. While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns.” Seth Klarman

"The strategy has its cycles based on the overall level of deal activity as well as the supply of capital." John Paulson

Buffett succinctly outlined the requirements for successful merger arbitrage in his 1998 letter..

“To evaluate arbitrage situations you must answer four questions 1) How likely is it that the promised event will indeed occur? How long will your money be tied up? 3) What chance is there that something still better will transpire – a competing takeover bid, for example? And 4) what will happen if the event does not take place because of anti-trust action, financing glitches etc?” Warren Buffett

The key to successfully employing merger arbitrage is to avoid deal breaks.  

"Risk arbitrage is not about making money, it's about not losing money." John Paulson

"The common characteristics of deals that break are poor earnings, an inability to consummate financing and/or regulatory obstacles. By eliminating deals that exhibit these characteristics, one can reduce the insistence of deal breakage." John Paulson

John Paulson, of Paulson Partners outlines his strategy for success..

"Our particular strategy to manage the portfolio for outperformance is comprised of five basic principles: 1) avoid deals that may break, 2) optimise returns from the spread portfolio, 3) weight the portfolio to possible competitive bid situations 4) focus on deals with unique structures that offer high returns; and 5) selectively short the weaker transactions." John Paulson

While merger arbitrage is unlikely to offer the same opportunity for returns as finding compounding machines, at times it can be a useful complement to value investing. Over the years, the best merger arbitrage opportunities I've witnessed are deals with very low conditionality that provide optionality for a bidding war. In these situations the return profile can move from negative to positive asymmetry. It's interesting, that despite John Paulsen's history in merger arbitrage it was buying sub-prime CDS's with massive positive asymmetry that made him billions. He risked a small amount for a massive pay-off.

Further reading - 

The Arbitrage Series - Part 1

“Because my mother isn’t here tonight, I’ll even confess to you that I have been an arbitrageur.” Warren Buffett

Arbitrage can be defined as 'the simultaneous or near simultaneous purchase and sale of the same securities or commodities in different markets to make a profit on the (often small) differences in price'.

This essay will take a brief look at 'classic arbitrage' and 'risk arbitrage'. Part two of the series will cover 'merger arbitrage', part three will cover 'time arbitrage.'

'Classic Arbitrage' refers to, for example, a trader noting a price differential between New York and London gold prices and then buying gold in the cheaper market to quickly on sell in the more expensive market to capture the 'spread' [ie profit] with almost no risk. Gold prices in London were kept in line with New York, as arbitrageurs like this trader exploited any pricing anomalies.    

"A century ago, when you bought the same security in New York and London, there was just a little variation in price from one city to the other. The professional bought the identical security in one city and sold it in another for a very small, but almost sure, profit." Roy Neuberger

With the rapid advancement of high-speed communications and computer technology, the traditional landscape of classic arbitrage has undergone a profound transformation. A contemporary illustration of this shift is embodied in the practices of high-frequency traders, who exploit pricing differentials across various stock exchanges within each market. These traders leverage sophisticated algorithms capable of intercepting trade data at lightning speed, executing market orders within nanoseconds to capitalize on pricing inefficiencies.

In this dynamic environment, computers are strategically positioned at exchanges, incurring premium rents for co-location, to gain an early advantage in accessing market data. Employing cutting-edge technology, such as microwave communication and state-of-the-art computer chips and low-latency order routing. Their objective is often to identify potential orders en route to other exchanges and execute ahead of them ["dirty poker?"]

The ascendance of these automated systems marks the demise of the era of 'classic arbitrage' for human participants. The rise of the machines signifies a paradigm shift, relegating traditional arbitrage strategies to obsolescence in the face of technologically-driven market dynamics.

The key idea in classic arbitrage is taking advantage of a pricing inefficiency with the absence of risk.

"Risk arbitrage" strategically exploits pricing inefficiencies arising from trading imbalances or information uncertainty triggered by various corporate events. These events encompass mergers, tender offers, liquidations, spin-offs, stub trades, and corporate reorganizations, among others.

The arbitrageur's primary goal is to seize the spread between the current trading price and the genuine value of the security. This spread encapsulates both the time value of money until the event concludes and a risk premium associated with the potential non-completion of the deal, hence the epithet 'risk' arbitrage.

Fundamentally, the arbitrageur endeavors to pinpoint mispriced risks within the market. Several factors contribute to this mispricing, such as a stock's exit from an equity index, a lack of Wall Street coverage for a spun-off company, the stigma surrounding a bankruptcy reorganization, heightened risk aversion due to uncertainties about a deal's success, involvement in cross-border transactions outside existing shareholder mandates, or the intricacies and lack of understanding regarding the nuances of the event.

"Since World War 1 the definition of arbitrage - or 'risk arbitrage', as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganisation, liquidation, self-tender etc." Warren Buffett

“Risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.” Seth Klarman

The strength of 'risk arbitrage' lies in its low correlation with the broader stock market, attributed to the defined timeline associated with the event that is anticipated to rectify the pricing anomaly. This inherent characteristic serves as a safeguard for the portfolio during market downturns. Such investments are commonly denoted as 'special situations' or 'event investing.'

"The risk pertains not primarily to general market behaviour (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialise." Warren Buffett 1963

“In the first place, with respect to a special situation as it is known in Wall Street. That is a security which upon study is believed to have a probability of increasing in value for reasons not related to the movement in stock prices in general, but related to some development in the company’s affairs. That would be particularly a matter such as recapitalization and re-organisation, merger and so forth.” Ben Graham

"The unique aspect of the strategy is its ability to earn attractive returns that are not dependent on the market's direction." John Paulson

"Our goal is to make money independent of the direction of the market.. We always do this through arbitrage." Brian Stark

"Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price.” Seth Klarman

Warren Buffett referred to these types of investments as 'work-outs' and employed the strategies at both the Buffett Partnership and then Berkshire Hathaway.

"Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%." Warren Buffett, 1988

Buffett recognised the benefits risk arbitrage positions would add to the overall portfolio. In down markets, arbitrage positions tend to outperform. While they are likely to be a drag on performance in strong bull markets, it's outperformance in down markets which is the key to high long term returns.

"I continue to attempt to invest in situations at least partially insulated from the behaviour of the general market." Warren Buffett, 1960

"This category produces more steady absolute profits from year to year than the generals [fundamental value investments] do. In years of market decline, it piles up a big edge for us; during bull markets it is a drag on performance. On a long term basis, I expect to achieve the same sort of margin over the Dow attained by generals." Warren Buffett, 1963

Although risk arbitrage returns typically demonstrate a lack of correlation with the overall market, it's essential to acknowledge that during periods of market stress, correlations often elevate. This occurs as mergers and tender offers are more likely to fail as acquirers re-assess the prices they are prepared to pay, deteriorating business conditions may trigger material adverse change conditions, market-out-clauses come into effect, financing dries up or spin-offs trade poorly. Spreads can also widen if dedicated arbitrage funds experience increasing redemptions.  

"The greatest risk in arbitrage is if capital leaves at the wrong time. You are attempting to exploit temporary mis-pricings between one security and another. Most of your success comes when the correct relationship between those securities is restored. When the relationship is out of whack and your capital leaves is when you get hurt." Brian Stark

As the arbitrageur is collecting the time value of money until deal completion, plus the risk premium for the risk of deal failure, the return can be computed as an annualised rate of return. This return can then be compared to current interest rates. When interest rates are low, annualised returns from risk arbitrage also tend to be low. Some mutual funds use arbitrage as a proxy for cash when they are nervous about markets but mandated to remain fully invested. Warren Buffett uses arbitrage as a proxy for cash, but only when returns are attractive. 

"Arbitrage positions are a substitute for short-term cash equivalents, and during the year we held relatively low levels of cash. In the rest of the year we had a fairly good-sized cash position and even so chose not to engage in arbitrage. The main reason was corporate transactions that made no economic sense to us; arbitraging such deals comes to close to playing the greater fool game (As Wall Streeter Ray DeVoe says: 'Fools rush in where angels fear to trade)." Warren Buffett, 1989

While risk arbitrage can serve as a viable alternative to cash, it comes with a notable caveat—when deals fall through, the resulting returns bear little resemblance to cash returns. In instances like merger arbitrage and tender offers, the losses incurred can be disproportionately higher, often ranging from 10 to 20 times the anticipated return from the successful completion of the deal. This inherent asymmetry is likened to the metaphor of 'picking up nickels in front of a steamroller,' emphasizing the perilous nature of the strategy.

Recognizing this risk, many investors adopt a strategy of diversification and impose limits on position sizes to effectively mitigate the potential downsides inherent in risk arbitrage. This cautious approach aims to strike a balance between the pursuit of returns and the prudence required to navigate the inherent uncertainties associated with these investment endeavors.

"The gross profits in many 'work-outs' appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return." Warren Buffett

Many specialist investors use leverage which enhances the annualised returns, but may significantly increase the risk profile. While there is no optimal level of debt, an investor must consider the impact on the portfolio in stressed market conditions or when there are multiple deal breaks.  

"I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behaviour. My self imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs." Warren Buffett

"We believe that reasonably leveraged and well-hedge arbitrage portfolios are considerably less risky than unhedged, outright equity portfolios." Brian Stark

Successful risk arbitrage requires identifying the attractive potential investments where the probability of success is high.  

“We will engage in arbitrage from time to time – sometimes on a large scale – but only when we like the odds.” Warren Buffett

 "For every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced." Warren Buffett

The strategy tends to be cyclical and like all forms of investing, this style will not guarantee success. At times when interest rates are low, there is a surge in M&A activity or an excess of capital pursuing too few available deals, returns maybe unattractive. 

"Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year, or for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: for every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better strategy than selecting a portfolio by throwing darts.” Warren Buffett, 1988

"We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. In our activities, we will heed the wisdom of Herb Stein: "If something can’t go on forever, it will end." Warren Buffett, 1988

Even the best arbitrageurs can have bad luck. The key is to ensure the portfolio can handle the downside should the worst case scenario happen.

"Our experience in workouts this year has been atrocious - during this period I have felt like the bird that inadvertently flew into the middle of a badminton game." Warren Buffett, 1969

Engaging in risk arbitrage has the potential to enhance portfolio returns, but it's certainly not a pursuit for the faint-hearted. This highly specialized strategy demands a diverse skill set for effective execution. Just like any form of investing, success hinges on having a distinct edge, operating within one's circle of competence, and meticulously assessing each investment within the broader context of the entire portfolio.

"Corporations will forever be buying, selling and restructuring their way into better businesses, creating fodder for event-driven investors for years to come." Jason Huemer

Further suggested reading:

"The hedge fund manager's edge: an overview of event investing" Chapter 8 - Jason Huemer.  Evaluating and Implementing Hedge Fund Strategies" - Third Edition